Pain in Cryptocurrency Markets and Regulatory Uncertainty Create Risk for Coinbase

Equity Analyst

Michael Miller

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As the leading U.S.-based cryptocurrency exchange, Coinbase has positioned itself as the reliable on-ramp to the cryptocurrency space for new and experienced cryptocurrency traders alike. The company’s reputation, regulatory compliance, and record as a custodian have allowed it to maintain transaction fees above many of its peers despite operating in a crowded field with hundreds of competing firms trying to grab market share. Unlike traditional exchanges in the U.S., Coinbase fulfills multiple roles in the trading ecosystem by acting as an exchange, asset custodian, and broker. Coinbase has continued to branch off into adjacent businesses offering the stablecoin USDC through its partnership with Circle, a crypto debit card, blockchain infrastructure, and data analytics services. 

While these new businesses expand its presence in the cryptocurrency space and add new revenue streams, the company earns the majority of its income through only two sources, interest income from its USDC partnership and the transaction fees traders pay when they trade on Coinbase’s platform. Coinbase's trading fees are charged as a percentage of trade’s total value and the bulk of Coinbase's trading revenue comes from retail traders, who are drawn by strong cryptocurrency markets and repelled by weak ones. This creates a strong correlation between Coinbase’s trading fee revenue and the performance of the cryptocurrency market. This has been to Coinbase's disadvantage in 2023, as a severe market correction in cryptocurrency has left the company unprofitable.

Moreover, Coinbase faces major regulatory challenges as the SEC has accused it of acting as an unregistered securities exchange and offering unregistered securities through its staking service. On a more positive note, Coinbase has drastically reduced its operating expenses in 2023, a difficult but necessary step after the firm allowed its costs to grow to unmaintainable levels in 2022 and 2021. While the timing behind a potential recovery in cryptocurrency prices is uncertain, Coinbase's leaner cost structure and significant financial resources means it can maintain itself for the foreseeable future in current market conditions.

Business Strategy & Outlook

In our view, Coinbase does not have an economic moat despite being the leading cryptocurrency exchange in the United States. Coinbase has been able to carve out a strong place in the cryptocurrency exchange industry by intentionally positioning itself as a reliable and compliant place to buy and sell cryptocurrency in an industry filled with risk, weak security practices, and spotty regulatory enforcement. This has allowed the company to successfully charge fees higher than many of its peers while building a large pool of liquidity on its platform. However, Coinbase is inherently reliant on the growth and success of bitcoin, ethereum, and other cryptocurrencies for generating returns on its invested capital. Cryptocurrency is still highly speculative, and the long-term success and viability is by no means guaranteed. Speculation on future price appreciation remains a key part of the space’s appeal, particularly in the less well-known "alt coins," creating further uncertainty about the long-term value and longevity of current prices. Coinbase has built a strong competitive position for itself, but without more confidence in the long-term viability of cryptocurrency as an asset class there is too much potential for Coinbase's returns on invested capital to rapidly evaporate for us to award the company a moat. 

Financial exchanges in general often benefit from network effects: as more buyers and sellers utilize a financial exchange, the order book deepens, and bid-ask spreads tighten. More trading volume generally leads to better liquidity, allowing buyers and sellers to enter and exit their positions with less impact on the price of the asset, reducing their implicit trading costs. Depending on the asset being traded, the benefit from having less market impact is often greater than any savings that could be achieved by using another exchange with lower transaction fees. As a result, there is often the tendency for liquidity to pool with higher trading volume, leading to lower costs, which in turn leads to even higher trading volume as buyers and sellers are drawn by better execution. For major trading pairs like bitcoin to U.S. dollars this is less of a concern as there is a large amount of liquidity available globally, but less well-known cryptocurrencies like MATIC or crypto-to-crypto trading pairs have smaller markets and demonstrate more substantial liquidity pooling. In 2022 more than 45% of Coinbase’s total trading volume came from crypto assets other than ethereum or bitcoin, and the exchange’s ability to support markets for these alt coins is a competitive advantage, especially as Coinbase has focused on expanding the number of supported trading pairs as a growth strategy. However, these alt coins are even more reliant on speculative energy to support their current valuations than bitcoin or ethereum and this class of cryptocurrency has typically seen sharper cyclical behavior. While listing more of these volatile coins helps Coinbase generate additional returns, it makes the company all the more dependent on the longevity and health of cryptocurrency to generate those returns. 

For cryptocurrency exchanges, network effects are compounded by technical limitations of current blockchain networks. With existing protocols, transactions on the bitcoin or ethereum network are too slow and expensive to support the level of trading volume seen on even a single major exchange. Moving assets from one “wallet” to another on the network can take minutes to even hours and pricing is prone to spiking during periods of congestion. As a solution to this issue, Coinbase and other exchanges act as both exchange and asset custodian. With this model, when a trader sells bitcoin to another trader the coins in question never leave Coinbase’s “wallet” because both ends of the trade are on Coinbase’s platform. Coinbase merely notes the change internally and keeps the transaction off the blockchain until one of the traders withdraws assets from the exchange. Only once crypto assets are removed or added to the platform is a transaction logged to a blockchain network, allowing for the free trading of cryptocurrencies without the delays or costs associated with blockchain networks.

Cryptocurrency custodianship is a key part of Coinbase’s operating model, and the company ended the second quarter of 2022 with over $124 billion in client-owned cryptocurrency on its platform, more than 11% of the total outstanding market capitalization at the time. The result of this model is that traders need to keep assets at the exchange if they intend to trade on it. This promotes liquidity pooling as traders are incentivized to focus their trading on a smaller selection of exchanges rather than spread their capital around. Retail investors, who still make up a major portion of the cryptocurrency market, are likely to be put off by the inconvenience of having their assets split up at multiple exchanges and are more likely to just trade at a single exchange. 

Inside of an industry where regulatory enforcement can be spotty and a number of high-profile failures have led to significant losses, Coinbase has consciously tried to position itself as a safe and fully compliant exchange that can provide institutional and retail traders a reliable platform to trade on. The company is registered in the United States and its decision to become publicly listed follows this strategy. Engagement with the U.S. regulatory regime does come with costs; Coinbase avoids listing cryptocurrencies that could be classified as unregistered securities by the SEC, limiting the number of trading pairs on its platform relative to some of its competitors. In December 2020, Coinbase announced that it was suspending trading of XRP, the third-largest cryptocurrency at the time, after the SEC filed a case against its parent company Ripple, accusing it of profiting from the sale of unregistered securities. With $17 billion in trading volume and $108.6 million in revenue in 2020, XRP trading was a material piece of Coinbase’s business and removing it from the platform represented a tangible cost of complying with U.S. regulators, particularly because many of Coinbase’s international competitors still allowed the trading of XRP. Additionally, know-your- customer and anti-money-laundering compliance adds costs and, given the ethos of decentralization and privacy shared by many participants in the cryptocurrency economy, strict adherence to these procedures can chase away potential users of the platform. 

While these are real costs associated with Coinbase’s compliance with U.S. and other nation’s regulatory regimes, the firm does benefit from the strategy it has chosen, and the costs can be seen as an investment in building a brand intangible asset. Coinbase is well known as a safe exchange for experienced traders and newcomers alike. The value of this brand reputation is significant when considered in the context of the severe risk cryptocurrency traders face when it comes to exchange hacks and other security issues. Because the exchanges act as custodians they are prime targets for theft and the track record of the industry as a custodian of assets is poor, with billions in client assets lost to theft since 2014. Well-established exchanges have developed security procedures and have had success in limiting (but not eliminating) losses in recent years. Larger exchanges with strong balance sheets are also often capable of using their own financial reserves to cover their client’s losses when a theft occurs. When industry leader Binance lost 7,000 bitcoin to theft in 2019 it was able to refund its clients without issue. Traders at the smaller Cryptomania exchange were less fortunate, as it was sent into liquidation after losing client funds in a hack that same year. This creates a clear incentive for traders to stick with established exchanges with significant financial reserves over small startups. 

While enforcement of rules has historically been spotty, regulatory interest in cryptocurrency has steadily increased, particularly following the collapse of FTX. At the end of 2020, in order to avoid regulatory action, industry leaders Binance and Huobi announced a crackdown on U.S. users of their platform, warning U.S.-based customers to move their funds or risk losing access, leaving Coinbase as the largest exchange with unrestricted access to the U.S. market. In 2021 Japan reiterated that Binance is not registered to do business in the country, the exchange stopped operating in Ontario to avoid securities regulation, and was banned from offering cryptocurrency derivatives by U.K. regulators. Meanwhile, in 2021 Coinbase received a license to provide trading and custodial services in Germany and received approval from Japanese regulators to enter the market. However, Coinbase faces regulatory challenges of its own, with the company currently being sued by the SEC over its staking services and some of the cryptocurrencies it offers trading services for. Coinbase has decided to fight the accusations in court and the ultimate resolution of the case will be a major determinant of the firm's position in its primary market. Until then, regulatory uncertainty will remain a major risk point for the firm. 

Coinbase’s network effects, switching costs, and intangible assets have allowed it to stand out and increase market share in a crowded industry. Because unregistered exchanges require little in the way of trade surveillance, customer verification, and record keeping, the amount of capital required to start a new exchange is minimal. There are over 400 active exchanges; however, it is far more difficult to attract trading volume than it is to start an exchange, and the majority of these exchanges are tiny compared with the major firms (exact figures are difficult to determine because of the questionable nature of self-reported trading volume from less-established firms). Liquidity pooling, a desire for safety, and the ability to offer related services have led established exchanges to grow in size while simultaneously fending off fee compression. We believe that Coinbase established a good competitive position, particularly as the collapse of major competitor justifies its premium pricing. However, the long-term longevity of the industry as a whole is not guaranteed and Coinbase's own regulatory challenges are material. There remains significant underlying risk that confidence and interest in cryptocurrencies could deteriorate further or that government acquiescence of cryptocurrency shifts into deeper hostility. In our view, the risk of a material decay in the company’s position is too great to award it a narrow or wide moat rating.

None

Economic Moat

Coinbase

Coinbase Global, Inc. operates as a secure hosted bitcoin wallet to purchase and use bitcoin. It provides merchant tools that enable companies to accept payments in bitcoin by incorporating a single button. The company was founded by Brian Armstrong in 2012 and is headquartered in San Francisco, CA.

Earnings data Q3 2023

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Coinbase Global, Inc. engages in technology and financial infrastructure products and services. It offers crypto-powered technologies including self-custody wallets, decentralized apps and services, and open community engagement platforms. The company was founded by Brian Armstrong in 2012 and is headquartered in San Francisco, CA.

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